Chevron What did we learn.pdf (221 kb)
The long running debt transfer pricing dispute between Chevron Australia and the Australian Taxation Office is over.
The Hon Kelly O’Dwyer MP, the Minister for Revenue and Financial Services, said last Friday that the Turnbull Government welcomed the withdrawal of Chevron’s appeal to the High Court over the ATO’s assessment of $340 million in tax and penalties for interest payments made to a Chevron subsidiary in the USA.
The Minister went on to say that ‘The ATO’s initial estimates are that the Chevron decision will bring in more than $10 billion dollars of additional revenue over the next ten years in relation to transfer pricing of related party financing alone.’
Chevron’s decision to withdraw its appeal means that, for the time being, the Full Federal Court’s decision handed down in April this year represents the leading authority on Australian transfer pricing law. Given that this decision dealt with a very specific fact pattern, its application in many other situations will not necessarily be straightforward. Further court cases in this area may be needed if the ATO is to bring in the additional revenue flagged by the Minister.
The Chevron case addressed just one related party loan, fought mainly under our ‘old’ transfer pricing rules in Div.13. Questions will arise as to how to apply the principles arising from the case to other circumstances, including transactions subject to our ‘new’ and somewhat different (and self-executing) transfer pricing rules in Subdiv.815-B.
It is worth pausing to ask, what did we learn from the Chevron litigation? Understandably, a lot of judicial ink was spilled parsing the text of the old and new provisions, but here are some key practical observations emerging from the case. Further and more detailed comments are contained in our Tax Brief on the Full Federal Court’s decision.
Lesson 1. The terms of the deal, as well as its price, are open to challenge, but much uncertainty remains
Chevron’s case was essentially that the ATO was limited to working out a price: the interest rate that would be paid by a stand-alone borrower from an independent lender for a loan structured in the identical terms to the credit facility in question.
Allsop CJ made it clear that this can’t be accepted because it effectively ‘dooms to failure’ the entire point of transfer pricing rules. ‘All one would have to do would be to constrain internally the transaction to give the highest price and include or omit terms of the agreement that would never be included or omitted in an arm’s length transaction and which are not driven or dictated by commercial or operational imperatives, as the foundation for assessing an hypothesised arm’s length consideration. Such unrealistic inflexibility would undermine the sensible operation of the [law] …’ The trial judge put it this way, ‘Division 13 does not permit reasoning that reaches a non-arm’s length interest rate on the basis that the actual interest rate is as high as it is because of the rating attributed to the borrower or borrowing, which rating relies on the absence of arm’s length consideration given by the borrower.’
However, even in the straightforward case of adjusting the terms of a loan, there is limited guidance arising from the judgments in Chevron, in relation to when the adjustments should relate to:
- the quantum of the loan;
- the terms of the loan, other than the interest rate; and
- actions of third parties to the transaction, for example the use of parent company guarantees, loan insurance or credit default swaps.
The uncertainties become more pronounced when the facts become more complicated. For example, how can the approach taken by the primary judge and the Full Federal Court be applied for example where:
- the relevant taxpayer is a subsidiary of a multinational economic group which operates across various industries, and not just one industry;
- the relevant taxpayer is a member of a group which has a policy of guaranteeing subsidiary debt in some, but not all, circumstances;
- the transaction is complex and could be implemented in multiple different ways; or
- the transaction involves an entity that is a member of a group with an Australian parent company?
Lesson 2. The right evidence is (still) crucial
This case involved an inordinate number of expert witnesses called by each side. Unfortunately for both sides, the expert evidence was almost always regarded by the trial judge as deficient in one or more respects:
- some evidence was discounted because it did not address the text of the legislation (e.g., the opinions of transfer pricing economists ‘appear not to be founded in the statutory language which the Court must apply’);
- some evidence was discounted because it started from wrong assumptions (e.g., an assumption that the borrower was not a subsidiary of Chevron or that the loan should be denominated in USD);
- some evidence was irrelevant because it was being used to reject an argument from the other side that was also wrong (e.g., what would have been the optimal currency to borrow in); and
- some evidence was simply inadmissible under our laws of evidence (e.g., evidence about the history and meaning of passages in the OECD’s Transfer Pricing Guidelines or how the US understands the Australia-US tax treaty to work).
More importantly, neither side was able to convince the judges that they had found data about third party transactions which were sufficiently comparable and could be used to benchmark the interest rate on the loan in dispute. Or to put it the other way, each side managed to convince the judge that the comparables presented by the other side were not really comparable at all. Much of that problem must be due to the fact, accepted by the Court, ‘that there were no loans or bonds in the market with such a lack of financial covenants.’ In the absence of a clear and obvious comparable, the experts made their own judgments and estimations, which the judge found unconvincing.
But it would be a mistake for other taxpayers to assume that the search for comparable transactions is futile and a waste of time. Nothing said in Chevron removes the need (prescribed in our current transfer pricing rules and in the OECD’s Transfer Pricing Guidelines) to seek out such comparable data where it exists. Rather, the case shows some of the pitfalls in trying to handle that process.
Lesson 3. The ATO reserves the right to challenge the currency of a transaction
While the ATO appears to have won the war, it lost some important skirmishes along the way. One issue revolved around whether the taxpayer’s decision to borrow in AUD should be respected. The ATO basically argued that the currency of the loan either was USD, or should have been USD. On either view, an arm’s length interest rate would have been several percentage points below the rate being charged for a loan denominated in AUD.
The ATO ran this argument before the trial judge and on appeal to the Full Federal Court. The trial judge found that the loan was in fact in AUD and the Full Court held against the taxpayer without needing to decide this issue.
So the ATO did not get the ruling it wanted – that choosing the ‘wrong currency’ can be challenged as a transfer pricing matter – but they have not given up on this issue. In PCG 2017/D4 (see our Riposte) the ATO prescribes demerit points where the currency of the loan is not the same as the currency in which the borrower earns the majority of its revenues. If it borrows in AUD because its expenses are in AUD, that apparently doesn’t matter. And if it borrows in a currency with a cheaper interest rate, that apparently doesn’t assist either. So Australian resident companies cannot just always transact in AUD; the ATO will seemingly decide whether AUD is appropriate.
Lesson 4. Orphan theory doesn’t work
The idea of the arm’s length price is, the price that would have been agreed ‘between independent parties dealing at arm’s length …’ Chevron argued this meant the rate for a loan by a stand-alone company borrowing from an unrelated lender – only that transaction would be one between truly independent parties. This had the implication there was no room for presuming there would be ‘implicit parental support’ – the idea that a parent company will probably come to the rescue of a subsidiary in difficulties. An anonymous stand-alone company does not have Chevron implicitly guaranteeing its debts, and so the interest rate is higher.
The Court rejected this approach saying ‘the independence hypothesis does not necessarily require the detachment of the taxpayer … from the group which it inhabits …’ The borrower under the hypothetical loan is also a subsidiary of the Chevron group.
In the trial, one expert witness gave evidence that, ‘in the absence of a legally binding document, the financial strength of the parent company should not be [and was not] considered as having a positive impact to the risk rating of its subsidiary.’ So, even if the borrower remains affiliated to Chevron, apparently only a real guarantee from the parent company matters to bankers when they set an interest rate.
Although there was no ‘real guarantee’ in this case, Allsop CJ held that ‘If the evidence reveals (as it did here) that the borrower is part of a group that has a policy to borrow externally at the lowest cost and that has a policy that the parent will generally provide a third party guarantee for a subsidiary that is borrowing externally, there is no reason to ignore those essential facts in order to assess the hypothetical consideration to be given.’
Lesson 5. The relevance and pricing of guarantees is uncertain
As we noted in our earlier Tax Brief on the Full Federal Court’s decision, the OECD’s transfer pricing guidance to date relates to the common situation where a parent company (i) actually guarantees a subsidiary’s debt and (ii) the debt is borrowed from an external lender.
The Full Federal Court in the Chevron decision raises an intriguing question about whether the same logic applies to debt borrowed from an internal lender. Or to put this another way, if a parent company were to provide an explicit guarantee for a subsidiary’s borrowings from another member of the group, can the parent charge a fee for this service which the borrower could deduct? And there is an even more speculative question: if a parent company is only presumed to guarantee a subsidiary’s borrowings (being borrowing from another member of the group), can the parent charge a fee for this presumed service which the borrower could deduct?
Lesson 6. Review potentially applicable group borrowing policies
The interest rate charged by the US lender to the Australian borrower in Chevron was approximately 9% due largely to the lack of security, operating and financial covenants and parental guarantee (as well as the currency of the loan). But there was evidence that the ‘policy of the parent … [was] to borrow externally at the lowest rate possible [and] it was usual commercial policy of the parent of the group for a parent company guarantee to be provided by it (the parent) for external borrowings by subsidiaries.’
If the terms of an intra-group borrowing appear at odds with the group policy on external borrowings, that may cause difficulty and will need to be explained.
Lesson 7. The pricing and supporting documentation for existing and proposed cross border loans will need careful review
It seems clear that the judgments in Chevron have changed the understanding of Australia’s transfer pricing rules in a number of key respects. Although the case was fought mainly on the ‘old’ transfer pricing rules, the decision will also have implications for our current rules, and the way that the ATO is likely to apply them. Because there have been surprisingly few decisions anywhere in the world on the important issue of debt transfer pricing, the Chevron case has been followed very closely at an international level. It will be interesting to see whether and how other countries and the OECD respond to the decision.
Australian and foreign owned multinational groups would be well advised to review the pricing arrangements (and supporting documentation) for existing cross border related party debt, as well as ensuring that the interest rates and any guarantee fees on new loans, take due consideration of the principles emerging from this landmark piece of litigation.